1. Demand, Supply, and Market Equilibrium
Chapter 3
Demand, Supply, and Market Equilibrium
This chapter provides an introduction to demand and supply concepts. Both demand and supply are defined and illustrated; determinants of demand and supply are listed and explained. The concept of equilibrium and the effects of changes in demand and supply on equilibrium price and quantity are explained and illustrated. The chapter also includes brief discussions of efficiency (productive and allocative) and price controls (floors and ceilings).
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Markets Interaction between buyers and sellers Markets may be:
Local
National
International
Price is discovered in the interactions of buyers and sellers
In this chapter the focus is on markets that are competitive. This requires large numbers of buyers and sellers acting independently.
Local markets include such markets as the farmer’s market that brings together buyers and sellers of produce in the summer.
National markets include markets like the U.S. real estate market and international markets like the New York Stock Exchange.
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3. Demand Schedule or curve
Amount consumers are willing and able to purchase at a given price
Other things equal
Individual demand
Market demand
To be part of the demand for a good, consumers have to be willing and able to purchase the good. When creating demand, we are assuming that the only factor that causes consumers to buy more or less is the price of the good. It is assumed that all other factors that influence the amount that consumers will buy are constant. Market demand is created by summing the individuals’ demand curves.
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4. Law of Demand
Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls.
Reasons:
Common sense
Law of diminishing marginal utility
Income effect and substitution effects
An inverse relationship exists between price and quantity demanded.
Prices act as obstacles for buyers and keep them from being able to buy everything that they ever wanted. So, it makes sense that with a limited income, consumers will buy more at lower prices.
Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service; i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first. Since additional units yield less utility, the price has to be lower to make up for less utility.
Income effect: A lower price increases the purchasing power of money income, enabling the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods.
Substitution effect: A lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.
The substitution and income effects occur whenever there is a change in price, and they further support the law of demand.
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5. The Demand Curve Individual Demand P Qd $5 4 3 2 1 10 20 35 55 80 P6 5 4 3 2 1
Quantity Demanded (latte per month)
Price (per latte) P
Individual
Demand P Qd $5 4 3 2 1 10 20 35 55 80
The demand curve illustrates the inverse relationship between price and quantity. The downward slope indicates a lower quantity (horizontal axis) at a higher price (vertical axis), and a higher quantity at a lower price, reflecting the law of demand. D Q
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6. Market Demand for Lattes, Three Buyers
Price
per Latte
Quantity Demanded
Total Qd
per week
Joe
Java
Sarah
Coffee
Mike
Cappuccino $5 10 12 8 30 4 20 23 17 60 3 35 39 26
100 2 55
154 1 80 87 54
221
There are three buyers in the market for lattes. The market demand is the horizontal summation of the individual demand curves of all of the consumers in the market. At a price of $3, for example, the three individual curves yield a total quantity demanded of 100 lattes.
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7. Market Demand + + = Joe Sarah Mike Market P P P P $3 $3 $3 $3 D D1 D235 Q 39 Q 26 Q
100 Q
By combining the individual demand curves for three different buyers, we can establish a market demand curve for all of the consumers in the market.
(= )
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8. Changes in Demand Demand Can Increase or Decrease Individual DemandP 6 5 4 3 2 1
Individual
Demand
Increase in demand
Price (per latte) D2
These changes in demand are to be distinguished from a change in quantity demanded, which is caused by a change in the price of the product and is shown by a movement from one point to another point on a fixed demand curve.
Decrease in Demand
Decrease in demand D1 D3 Q
Quantity Demanded (thousands of lattes per month)
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9. Changes in Demand Change in consumer tastes and preferences
Change in number of buyers
Change in income
Normal goods
Inferior goods
When most consumers experience the same change in tastes for a particular good, the demand for the good will change. If there is a preferable change in tastes, demand will increase. On the other hand, if there is an unfavorable change in tastes, demand will fall.
If there are more buyers in the market for a good, demand will increase, whereas when there are fewer buyers in the market for a good, demand will decrease.
Normal goods are goods that we buy more of as our incomes increase. Most of the goods that we buy are normal goods. We buy fewer normal goods when our income decreases.
Inferior goods are goods we buy more of as our income decreases. We buy fewer inferior goods as our income increases.
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10. Changes in Demand Change in prices of related goods Complements
Substitutes
Change in consumers’ expectations
Future prices
Future income
Complement goods are goods that we consume jointly. It isn’t beneficial to have one without its complement. When the price of one complement increases, the demand for the other complement decreases. When the price of one complement decreases, the demand for the other complement increases. Some examples: cars and gasoline; cars and tires; DVD players and DVDs.
Substitute goods are goods that we use in place of another. A perfect substitute is a good that we use in place of the other without any loss of satisfaction. If the price of one good increases, the demand for its substitute increases. If the price of one good decreases, the demand for the other substitute decreases. Some examples: Pepsi and Coke; beef and chicken.
If consumers expect the future price of a product to be higher, they increase their current demand for the product.
If consumers expect the future price of a product to be lower, they decrease their current demand for the product.
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11. Changes in Quantity Demanded
Change in demand is a shift of the demand curve
Change in quantity demanded is a movement from one point to another point on a fixed demand curve
It is important to distinguish between a change in demand and a change in the quantity demanded. A change in demand represents a shift of the demand curve to the right (an increase in demand) or to the left (a decrease in demand). It occurs because the consumer’s desire to purchase the product has changed. A change in the quantity demanded is a movement along a fixed demand curve caused by an increase or decrease in the price of a product.
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12. Supply Schedule or curve
The amount producers are willing and able to sell at a given price
Individual supply
Market supply
To be part of the supply of a good, producers have to be willing and able to produce the good. When creating supply, we are assuming that the only factor that causes firms to produce more or less is the price of the good. It is assumed that all other factors that influence the amount that firms will produce are constant. Market supply is created by summing the individual firms’ supply curves.
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13. Law of Supply
Other things equal, as the price rises, the quantity supplied rises and as the price falls, the quantity supplied falls.
Reason:
Price acts as an incentive to producers
At some point, costs will rise
Producers are willing to produce and sell more of their product at a high price than at a low price. There is a direct relationship between price and quantity supplied.
Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied.
Beyond some level of output, producers usually encounter increasing costs per added unit of output.
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14. Market Supply of Lattes
The Supply Curve 5 4 3 2 1 P
Market Supply of Lattes
Price per Latte Qs
per Month $5 60 4 50 3 35 2 20 1 5 S
Price (per latte)
Because price and quantity supplied are directly related, the supply curve graphs as an upsloping curve. Other things equal, producers will offer more of a product for sale as its price rises and less of the product for sale as its price falls. Q
Quantity Supplied (lattes per month)
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15. Changes in Supply Decrease in supply Increase in supply$6 5 4 3 2 1
Price (per latte) S3 S1
Decrease
in supply S2
A change in one or more of the determinants of supply causes a change in supply. An increase in supply is shown as a rightward shift of the supply curve, as from S1 to S2. A decrease in supply is depicted as a leftward shift of the curve, as from S1 to S3.
Increase
in supply Q
Quantity Supplied (thousands of lattes per month)
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16. Determinants of Supply
A change in resource prices
A change in technology
A change in the number of sellers
A change in taxes and subsidies
A change in prices of other goods
A change in producer expectations
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology, supply decreases.
If the number of sellers increases, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decreases, supply decreases. Economic losses in the market cause producers to leave the market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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17. Changes in Quantity Supplied
Change in supply is a shift in the supply curve
Change in the quantity supplied represents a movement along a supply curve
As with demand, a change in supply represents a shift in the supply curve caused by a change in one or more of the determinants of supply. A change in the quantity supplied is a movement along the supply curve caused by a change in the price of the product.
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18. Market Equilibrium
Equilibrium occurs where the demand curve and supply curve intersect
Surplus and shortage
Rationing function of prices
Efficient allocation
Productive efficiency
Allocative efficiency
The equilibrium price is also known as the market-clearing price. Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. This is an IMPORTANT point to recognize and remember. Note that it is NOT correct to say supply equals demand!
The rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.
At prices above this equilibrium, note that there is an excess quantity supplied, or a surplus.
At prices below this equilibrium, note that there is an excess quantity demanded, or shortage.
At equilibrium the markets are efficient. Firms are producing in the least costly manner, achieving productive efficiency. Price is equal to marginal cost, achieving allocative efficiency.
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19. Market Equilibrium P Qd P Qs Market Market Supply Demand 200 Sellers
200 Buyers 6 5 4 3 2 1
6,000 latte
surplus S P Qd P Qs
2,000
4,000
7,000
11,000
16,000 $5 4 3 2 1 $5 4 3 2 1
12,000
10,000
7,000
4,000
1,000
Price (per latte) 3
The intersection of the downsloping demand curve, D, and the upsloping supply curve, S, indicates the equilibrium price of $3 and equilibrium quantity of 7000 lattes per week.
The shortages of lattes at below-equilibrium prices (for example, 7000 bushels at $2) drive up the price. The higher prices increase the quantity supplied and reduce the quantity demanded until equilibrium is achieved. The surpluses caused by above-equilibrium prices (for example, 6000 lattes at $4) push the price down. As price drops, the quantity demanded rises and the quantity supplied falls until equilibrium is established. At the equilibrium price and quantity, there are neither shortages nor surpluses of lattes.
7,000 latte
shortage D 7
Quantity of lattes (thousands per month)
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20. Rationing Functions of Prices
The ability of the competitive forces of demand and supply to establish a price at which selling and buying decisions are consistent.
Prices automatically rise and fall and bring a market closer to equilibrium. Prices are the best tool for eliminating market shortages and surpluses.
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21. Changes in Demand and Equilibrium
D increase:
P, Q
D decrease:
P, Q P P S S D3 D2
An increase in demand results in an increase in price and an increase in quantity exchanged.
A decrease in demand results in a decrease in price and a decrease in the quantity exchanged. D4 D1
Increase in demand
Decrease in demand
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22. Changes in Supply and Equilibrium
S increase:
P, Q
S decrease:
P, Q P P S1 S4 S3 S2 D D
An increase in supply results in a decrease in price and an increase in the quantity exchanged.
A decrease in supply results in an increase in price and a decrease in the quantity exchanged.
Increase in supply
Decrease in supply
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23. Government-Set Prices
Price ceilings
Set below equilibrium price
Rationing problem
Black markets
Example: Rent control
Price ceilings are maximum prices that can be charged on a good. Price ceilings are set on goods that are considered to be necessities, but the equilibrium price is so high that many people are unable to purchase the item. To be effective, the price ceiling must be set below the equilibrium price. When price ceilings are placed on a good, this creates a chronic shortage, which makes it difficult to determine how to ration the limited output for all of the consumers who are willing and able to buy the good. The shortages often lead to black markets where the good is sold at a higher price than the price ceiling. Price ceilings distort the efficient allocation of resources.
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24. Government-Set Prices
$3.50 P0
Ceiling
3.00 PC
A price ceiling is a maximum legal price such as Pc. When the ceiling price is below the equilibrium price, a persistent product shortage results. Here that shortage is shown by the horizontal distance between Qd and Qs. D
Shortage Q Qs Q0 Qd
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25. Government-Set Prices
Price floors
Prices are set above the market price
Chronic surpluses
Example: Minimum wage laws
Price floors are minimum prices that can be charged for a good. Price floors are placed on goods that are considered to be necessities, but the equilibrium price is so low that it discourages production of the good. To be effective, the prices must be set above the market price, and this creates persistent surpluses in the market. Price floors distort the efficient allocation of resources.
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26. Government-Set Prices
Surplus
Floor
$3.00 Pf
2.00 P0
A price floor is a minimum legal price such as Pf. When the price floor is above the equilibrium price, a persistent product surplus results. Here that surplus is shown by the horizontal distance between Qs and Qd. D Q Qd Q0 Qs
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